Using a 401(k) to Supercharge a Roth

Let’s talk this time about a tax trick that may be available to you if you participate in a 401(k). The reason for the “may” is that – while the tax Code permits it – your individual plan may not. You have to inquire.

Let’s set it up.

How much money can you put into your 401(k) for 2015?

The answer is $18,000. If you are age 50 or over you can contribute an additional $6,000, meaning that you can put away up to $24,000.

Most 401(k)’s are tax-deductible. There are also Roth 401(k)’s. You do not get a tax break like you would with a regular 401(k), but you are putting away considerably more than you could with just a Roth IRA contribution.

Did you know that you might be able to put away more than $18,000 into your 401(k)?

How?

It has to do with tax arcana. A 401(k) is a type of “defined contribution” (DC) plan under the tax Code. One is allowed to contribute up to $53,000 to a DC plan for 2015. 

What happens to the difference between the $18,000 and the $53,000?

It depends. While the IRS says that one can go up to $53,000, your particular plan may not allow it. Your plan may cut you off at $18,000.

But there are many plans that will allow.  

Now we have something - if you can free-up the money.

Let’s say you max-out your 401(k). Your company also contributes $3,000. Combine the two and you have $21,000 ($18,000 plus $3,000) going to your 401(k) account. Subtract $21,000 from $53,000, leaving $32,000 that can you put in as a “post-tax” contribution. 

Did you notice that I said “post-tax” and not “Roth?” The reason is that a Roth 401(k) is limited to $18,000 just like a regular 401(k). While the money is after-tax, it is not yet “Roth.”

How do you make it Roth?

Prior to 2015, there had been much debate on how to do this and whether it could even be done. The issue was the interaction of the standard pro-rata rules for plan distributions with the unique ordering rule of Code Section 402(c)(2).

In general, the pro-rata rule requires you to calculate a pre- and post-tax percentage and then multiply that percentage times any distribution from a plan.

EXAMPLE: You have $100,000 in your 401(k). $80,000 is from deductible contributions, and $20,000 is from nondeductible. You want to roll $20,000 into a Roth account. You request the plan trustee to write you a $20,000 check, which you promptly deposit in a newly-opened Roth IRA account. 

           Will this work?

Through 2014 there was considerable doubt. It appeared that you were to calculate the following percentage: $20,000/$100,000 = 20%. This meant that only 20% of the $20,000 was sourced to nondeductible contributions. The remaining $16,000 was from deductible contributions, meaning that you had $16,000 of taxable income when you transferred the $20,000 to the Roth IRA. 

I admit, this is an esoteric tax trap.

But a trap it was. 

There were advisors who argued that there were ways to avoid this result. The problem was that no one was sure, and the IRS appeared to disagree with these advisors in Notice 2009-68. Most tax planners like to keep their tires on the pavement (so as not to get sued), so there was a big chill on what to do.

The IRS then issued Notice 2014-54 last September.

The IRS has clarified that the 401(k) can make two trustee-to-trustee disbursements: one for $80,000 (for the deductible part) and another of $20,000 (for the nondeductible). No more of that pro-rata percentage stuff.

There is one caveat: you have to zero-out the account if you want this result.

Starting in 2015, tax planners now have an answer.

Let’s loop back to where we started this discussion.

Let’s say that you make pretty good money. You are age 55. You sock away $59,000 in your 401(k) for five years. Wait, how did we get from $53,000 to $59,000? You are over age 50, so your DC limit is $59,000 (that is, $53,000 plus the $6,000 catch-up). Your first $24,000 is garden-variety deductible, as you do not have a Roth option. The remaining $35,000 is nondeductible. After 5 years you have $175,000 (that is, $35,000 times 5) you can potentially move to a Roth IRA. You may have to leave the company to do it, but that is another discussion.

Not a bad tax trick, though.

Taxing A Corvette

I came across an old case recently. It made me smile, as it reminded me of earlier – and skinnier – times.

Let’s set this up.

There are, broadly speaking, two accounting methods when deciding whether you have reportable income for a period: the cash method and the accrual method. There are a variety of sub, sorta- and who-actually-understands-this methods, but cash and accrual are enough for right now.

The cash method is easy: if you can deposit it at the bank you have income.  Maybe you decide not to deposit at the bank until next week, but it is still income today. Why? Because you can deposit it. The definition is “can” not “did.”

Accrual is trickier. Generally it means that you sent an invoice to someone. The act of invoicing means you have income, as someone owes you. What if you delay invoicing for a week or two? Well, then you have a variation on the above cash-basis reasoning: you could have but didn’t. Again, it is the “could,” not the “did,” that drives the test.

What if you are on the cash method and somebody pays you with property instead of cash? You have income. It makes sense when you remember that cash is a form of property. We have just gotten so used to it that we don’t think of cash that way. For tax purposes, though, someone paying you in asiago cheese and gluten-free crackers still represents income. Granted, we have to translate cheese-and-crackers into dollars, but income it is.

Let’s say that you played football. Not just any football, however. You were Vince Lombardi’s running back. It is December 31, and you and Lombardi and the Green Bay Packers are playing the New York Giants in the National Football League Championship.

COMMENT: NFL historians will immediately recognize that this was before the Super Bowl era. There was no game called the Super Bowl until the two leagues – the National Football League and the American Football League – merged in 1966. The first two Super Bowls were won tidily by Lombardi and the Packers. In Super Bowl 3 Joe Namath famously led the New York Jets over the Baltimore Colts.

So it is the championship game. You are the running back. It is December 31 and you are playing outside in Green Bay. I presume you are freezing. You run wild and score 19 points, establishing a league record. You are selected after the game by Sport Magazine as the most valuable player, which comes with the prize of a new Corvette. 

Sweet.

By the way, your Corvette is waiting for you in New York. It is now the evening of December 31, 1961.

Tax issue: Do you have income (the value of that Corvette) in 1961?

The IRS said you did.

But you throw the IRS a loop: the car is not income. No, siree. It was a gift. Alternatively, it is nontaxable to you as a prize or award.

I give you kudos, but the concept of a gift requires the presence of detached and disinterested generosity. While a creative argument, it could not be reasonably argued that a for-profit magazine was awarding an expensive car to the most valuable player of a televised sporting event out of a detached and disinterested generosity. It was much more likely that both Sport Magazine and General Motors were expecting publicity, advertising and social buzz from the award.

You still have your second argument, though.

Problem is, the prize or award exception requires you to receive it for an educational, artistic, scientific or civic achievement.

You argue your point: being a star football player “calls for a degree of artistry” requiring techniques based on “scientific” principles.

Seriously.

The Court decides:

We believe that petitioner should be caught behind the line of scrimmage on this particular offensive maneuver.”

You have income. And the Court gave us a great quote.

But when do you have income: 1961 or 1962?

The Court reasons through the obvious. You are in Green Bay. The car is in New York. You cannot get to that car - much less title it - unless you had Star Trek technology. However, it is 1961 and Star Trek is not on television yet. You have income in 1962, the following day.

Your tax case is seminal in developing the tax doctrine of constructive receipt. Normally constructive receipt accelerates when you have income, but it did not in your case.You could not have made it to the bank even if you wanted to.

So why did the IRS push the issue of 1961 versus 1962? They didn’t. Remember that you were arguing that the Corvette wasn’t taxable. The IRS had to fight back on that issue. The 1961 thing was a sidebar, albeit that is what the case is remembered for all these years later.

By the way, do you know which football player we have been talking about?

Ohio Offers Two Tax Amnesties

As part of the 2012/2013 budget bill, Ohio has authorized a general amnesty for selected state taxes, including personal income, school district, sales and commercial activity taxes.

This is an attractive amnesty program, although it does have one significant drawback. Under the program Ohio will abate all penalties and one-half the interest. Taxes eligible for the amnesty must have been due and payable as of May 1, 2011. This means that a 2010 individual income tax will be eligible (as it was due April 15, 2011), but a May 2011 sales tax return would not (as it was due June 23, 2011). In addition, you cannot have been previously contacted by Ohio.

Ohio expects full payment when you file these tax returns. Remember – this is a revenue raiser for the state.

The significant drawback? The general amnesty window is very brief: from May 1 to June 15, 2012.

There is a separate use tax amnesty that runs from October 1, 2011 to May 1, 2013.

Note: Use tax applies to purchases of taxable products or taxable services where the seller did not collect the Ohio sales tax. The use tax applies both to individuals and businesses. The use tax is the cousin to the Ohio sales tax. It serves to prohibit one from avoiding Ohio sales tax by purchasing items from another state (free of sales tax) and then bringing them into Ohio.

If one pays all use tax due on or after January 1, 2009, Ohio will waive or abate use tax owed for prior periods. There is also a non-interest payment program available for businesses not previously registered for use tax, although this option requires an officer to personally guarantee the tax debt. On the plus side, Ohio will allow the business up to seven years to pay the back taxes. Once again, you cannot have been previously contacted by Ohio.

IRS Modifies Streamlined Installment Payment Program

The IRS issued a memorandum on January 20, 2012 liberalizing streamlined installment agreements. I am happy with this change.

As a refresher, the advantage of the “streamlined” is that one does not have to provide financial information to the IRS. If you have gone through this effort, you may remember IRS Form 433 – the financial information form. This is where you provide financial detail such as monthly deposits and expenses. You will also attach documentation, including copies of bank statements as well as copies of your mortgage or rent advice and certain other expenses. 

The IRS has standards for broad household expenses, such as mortgage and utilities, clothing and personal effects, medical expenses and vehicle payment and operating expenses. The IRS is inclined to use their numbers, although they will allow you to document higher or additional expenses. You then have to persuade them that your numbers are better than theirs and do not reflect a “lavish” lifestyle or incorporate”excessive” expenses. To give you an idea, the IRS does not allow for payments on your credit cards. I am not sure if they consider credit card payments to be “lavish” or “excessive.”

The “streamlined” allows you to fast-forward through this.

The liberalized streamlined rules apply only to an individual taxpayer. They do not apply to corporations and other types of businesses. You can now enter streamlined if your assessed balance (taxes, interest and penalties) is less than $50,000, an increase from the previous $25,000. In addition, you now have 72 months to pay, an increase of one year from the previous 60 months.

The IRS does charge a small fee (either $104 or $52, depending on whether you permit direct deposit) for the payment plan. Any streamlined over $25,000 must be on direct deposit.

To clarify, you do not have to enter streamlined, even if your assessed balance is less than $50,000. You can go the normal route, provide information and pursue a more favorable payment plan.  You would do that if you are pursuing a partial pay, for example. You would certainly have to go that route if you are pressing for an offer in compromise. For many people, however, the increase from $25,000 to $50,000 and an additional year to pay may make all the difference.

Why would someone hesitate to provide a 433? For one, it can be a pain to assemble and complete. Also, you have to disclose your bank accounts, including bank account numbers, on the 433. Some people believe this makes it easier for the IRS to levy your bank account. Whether correct or not, you have provided the IRS a roadmap to your finances.